Sterling markets are bracing themselves for a bruising

Sterling markets are bracing themselves for a bruising – In July, consumer prices in the United Kingdom increased at an annual rate of 10.1%, marking a 40-year high. It’s a game-changer: Britain becomes the first G7 nation in the current economic cycle to surpass this psychological barrier, making it more difficult to defend the underlying economy against the emergence of inflationary expectations.

Inflation in the United Kingdom may decline in the next months, as gasoline costs decrease and crude oil falls below $90 per barrel. However, the Bank of England will have to look beyond this, since an increase in the energy-price ceiling in October would push annual inflation over 13% by year’s end. With official interest rates at 1.75 percent after six straight increases, the Monetary Policy Committee is scarcely in control of the situation when inflation exceeds five times its 2 percent objective.

Perhaps more unexpected is how caught off guard they were. Wednesday’s report, which followed Tuesday’s strong job and pay statistics, jolted sterling markets, which had been lulled into summer slumber by last week’s better-than-expected US CPI for July. The UK money markets have priced in a 50 basis-point rise at the next central bank meeting on September 10, which would be a repetition of this month’s outsized increase rather than a return to the more typical quarter-point move. Traders anticipate more forceful action to restrain increasing prices, particularly because the Old Lady has allowed the Federal Reserve — which began tightening four months after the BOE — to surpass it with more robust 75 basis-point rises.

The March 2023 sterling overnight futures contract indicates that official interest rates will peak around 3.75 percent in less than six months, with a 100 basis point repricing this month. The anticipation that borrowing costs would increase by 2 percentage points in such a short time may seem excessive, but it demonstrates how rapidly expectations are shifting. Wednesday’s Sonia futures transactions were up to 10 times the daily average as traders hurried to adjust their bets.

In anticipation of further rate rises, the yield curve for UK government bonds has inverted, with two-year rates 12 basis points higher than 10-year yields. It is the largest divergence since 2008, a reflection of the significant inversion in the US Treasury market. However, short-term gilts are just responding to events; the longer end of the gilt market is failing to accurately price chronic inflation threats.

Analysts at NatWest Group Plc anticipate 10-year gilt rates to peak at 3%, up from the current 2.3%, due in part to the assumption that government bond sales, net of redemptions, would increase to more than £200 billion ($240 billion) next year. The subsequent two years will need considerably more borrowing.

The BOE anticipates a moderate but prolonged recession beginning in the fourth quarter, but it may be mitigated by a large fiscal stimulus from the next prime minister, with Liz Truss projected to defeat Rishi Sunak and become the new tenant of 10 Downing Street.

The market for government bonds should be concerned about how the additional expenditure will be funded, given an increase in supply is imminent. It is the route of least resistance for a beleaguered administration confronted with a severe cost-of-living issue.

The Debt Management Office of the UK Treasury requested four more gilt auctions for the next quarter on Monday. It seems that increased gilt issuance will become a regular trend. In addition, the BOE will begin aggressive sales of its gilt holdings back into the market in September, creating a double whammy. This sale, along with ageing assets, will result in an annual balance-sheet decrease of £80 billion, the ramifications of which remain unknown.

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Gilts often fluctuate between the higher-yielding US Treasury and the much lower-yielding European benchmark German bund. In the next months, however, UK rates are set to approach their US counterparts, at least until there is concrete evidence that inflation has peaked. Unfortunately, by then the economy might very well be in freefall. The future for sterling traders is turbulent.

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